1

CEO Compensation

in Cooperatives versus Publicly Listed Firms

Li Feng

George Hendrikse1

This version: June 10, 2009

Abstract

A multiple activities principal-agent model regarding CEO compensation in cooperatives

is presented, capturing that cooperatives are not publicly listed and that they have to bring

the enterprise to value as well as to serve member interests. A cooperative dominates a

publicly listed firm in terms of efficiency when either activities are sufficiently

complementary, or additional information is considered in the performance measure.

Keywords: Compensation, performance measurement, cooperatives.

1 The authors are at Rotterdam School of Management, Erasmus University, Office T8-56, P.O. Box 1738,

3000 DR Rotterdam, 00-31-10-4088660, The Netherlands, lfeng@rsm.nl, ghendrikse@rsm.nl.

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Few factors are more important for a cooperative’s success than the manager.

Trechter et al, 1997

1 Introduction

Since the last decade, CEO compensation has received tremendous attention in both the

business and academic community. The large number of high-publicity scandals, the

enormous salaries paid to CEOs, and their celebrity status have created unprecedented

public interests in corporate governance (Weisbach, 2007). Inasmuch as the agency

approach captures the inherent divergence between the interests of the firm’s investors

and the professional management (Bebchuk and Fried, 2003), CEO compensation is often

cited as a real-world example of a principal–agent problem. A partial solution to this

problem is to utilize an incentive contract designed to pay the agent more when he

performs better. The incentive contract is based on a performance measurement system,

creating incentives that align the goal of the agent with that of the organization.

A substantial amount of research has focused on how executive compensation schemes

can help rectify the agency problem in IOFs (Investor Oriented Firms), especially

publicly listed companies, whereas the CEO compensation in other governance structures,

for example cooperatives, has received hardly attention. This can be justified to a certain

extent because the members-CEO relationship in cooperatives is similar to the investors-

CEO relationship in IOFs. Traditionally, the cooperative board of directors,

democratically chosen by and from the membership, was the main body governing the

activities and investments of the cooperative firm (Bijman, Hendrikse & van Oijen, 2008).

As the cooperative grows, the tasks facing the cooperative management call for strategies

or judgment far beyond the experience and competence of most members, professional

qualified management is hired to operate the firm. As a result, the members exercise their

authority mainly by critically following the policies of the management, rather than by

giving it directions (Trifon, 1961). Members would like to maximize their benefits

derived from the cooperatives, while the management is likely to pursue objectives of

organizational growth maximization, subject to continuity and employment security

(Vitaliano, 1983). This is similar in an IOF.

Despite of the similarities, the situation in cooperatives is more complex than a standard

principal-agent relationship. First, there is a group of principals whose interests differ.

The variety of members embodies aspects like their sizes, locations, risk aversion,

attitudes towards innovation, growth potential, member involvement, and financial

contributions to the cooperative. Due to the heterogeneity, the cooperative does not have

one locus for profit maximization but a separate locus for each member, giving rise to a

host of problems that attend collective choice (Staatz, 1987). Problems are manifested in

debates not only about pricing, financing and pooling policies, but also in the difficulty to

achieve consensus regarding specific performance targets (Hueth & Marcoul, 2008).

When colliding interests exist among principals, the agent’s tasks involve devising

workable compromises and acting as a neutral guardian of everybody’s priorities (Trifon,

1961).

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Secondly, the tasks of CEO is not one-dimensional because of “a cooperative’s goal of

jointly maximizing member and cooperative returns” (Peterson & Anderson, 1996, p376).

Members are users in addition to owners of the firm. They have at least two sets of

concerns: owner concerns and user concerns. Owner concerns revolve around the security

and overall profitability of their investments in the cooperative. User concerns include

issues of the pricing and quality of product and services, which influence the profitability

of their individual farm enterprise (Staatz, 1987). These two concerns are reflected in the

members’ expectation regarding the management.

Thirdly, there are no simple indicators of cooperative managerial performance and

automatic incentive systems (such as stock options) to close the gap in interests. Giving

the CEO equity in the business, a common way to tie the CEO’s wealth to firm

performance and thus to alleviate the principal-agent interests conflict in IOFs, is not

feasible. The reason is that a cooperative CEO is not eligible to hold equity in the

business and receives only limited benefits from such ownership given the fact that most

cooperative stock does not appreciate in value (Trechter et al, 1997).

It is difficult to assess the top manager’s contributions to a company due to the

complexity of his tasks (Blanchard et al, 1996). Given those additional complexities in

cooperatives, designing a contract ensuring the cooperative’s goals and the CEO’s

incentives are mutually compatible has to be even more difficult. Besides the easily

measurable index stock price or ROI (Return on Investment), more dimensions of the

CEO’s outputs concern the members and require efforts from him. Some researchers

point an accusatory finger at the efficiency of cooperatives and argue that cooperatives

suffer from a host of problems unique to this specific form of governance, including the

horizon problem that pushes the cooperative to pursue short-term benefits at the expense

of long-term earnings. Stewart (1993, p291) even asserts that a business cannot be

successfully run if its customers or suppliers are deeply involved in running it because

there is too much conflict of interest. Yet, cooperatives and IOFs coexist in many sectors

of most modern economies and compete for market share, especially in the agricultural

sector where cooperatives have played an active role for a very long time in many

countries. We aim to answer in the current paper the following question: How is the

cooperative CEO compensation determined by the special features of its governance

structure?

One way to position the article in terms of the principal-agent model is that it is in line

with the current theoretical developments. The classic principal-agent model highlights

the trade-off between the incentives (regarding one task) and risk. One development has

been that nowadays a trade-off is considered between the incentives intensity and the

allocation of attention among various activities. The other development is that repeated

principal-agent relationships are considered. This paper is to be positioned along the first

development as we consider a model where the agent allocates his attention over

upstream and downstream activities. Another way of positioning is that most studies

regarding contract choice in agrarian economies using the principal-agent model are

geared to the relationship between a landowner and a farmer (Hayami and Otsuka, 1993).

We address the relationship between farmers and the CEO of a cooperative. Finally, a

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variety of corporate forms has to be considered when studying the nature of the firm. A

cooperative is an informative counterfactual for the much studied publicly-listed

corporation (Hansmann, 1996).

This article is organized as follows. Section 2 distinguishes cooperatives from IOFs.

Section 3 uses a multi-task principal-agent model to characterize CEO compensation

schemes in cooperatives and IOFs. Section 4 formulates various extensions. Section 5

provides a number of empirical implications. Finally, section 5 concludes.

2 Cooperatives versus publicly listed firms

This section compares cooperatives with publicly listed firms regarding various aspects:

organizational objectives (i.e., member value in cooperatives), CEO activities, and

governance structure.

2.1 Member value

Members join a cooperative to achieve certain commercial and social objectives (LeVay,

1983; Barton, 1989). The German council of cooperatives (DGRV, 2008) specifies that a

cooperative has to serve joint economic, social, and cultural interests.2 Members are

owners as well as users. As the owners and investors, they want to bring the downstream

stage of production to value in order to receive dividends. As input suppliers, they derive

benefits from their transaction relationship with the cooperative firm. Therefore, the

members are concerned with both the value added at the cooperative firm and at their

own farm enterprises, and want to motivate their CEO to bring the outputs at both stages

jointly to maximum value. They care not only about the financial performance of the

cooperative in the same way as the investors of an IOF, but also about the impact of the

cooperative on their own farm portfolios, their positions in social structure, community

development, and so on. “Because of its goal to maximize value to members, a

cooperative will consider its members’ farm asset returns and not just its own.” For

example, “when the losses at the member level from abandoning the market exceed the

cooperative’s loss from staying in the market, then it is a rational decision for the

cooperative to stay” (Peterson & Anderson, 1996, p375). Thirkell (1993, p279) argues

that the use of organizational profit for measuring performance in a cooperative is not

only unnecessary but also often downright misleading. If the objective is member benefit

rather than financial performance of members’ investment in the cooperative, then it is

member benefit that should be measured, not the co-operative's conventional corporate

performance. Simply examining traditional financial statement data will not be adequate

(Peterson & Anderson, 1996, p376). In accordance with Hind (1997) who distinguishes

corporate-oriented aspirations and member-centered goals, we categorize member value

into value added at the cooperative firm and value added to the farm enterprises.

2 ‘Allgemeines Ziel von Genossenschaften ist, gemeinsame wirtschaftliche, soziale und kulturelle

Bedürfnisse zu Befriedigen’ (DGRV, 2008).

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Value added at the cooperative firm3

The financial performance of the cooperative concerns its members since they are the

residual claimants. The net income of a cooperative is distributed to its members in the

form of patronage refunds. On this aspect, members are happy with the cooperative’s and

CEO’s performance in the same sense investors in an IOF are happy with their firm’s

performance (Staatz, 1987). They count the cooperative’s financial performance on

various aspects: revenues, total assets, sales, local net income, local returns on assets,

local net margin, accounts receivable, ROI, production volume, or its performance

relative to neighboring enterprises.

Moreover, the flow of information between patrons and the firm may be better in

cooperatives than in IOFs, leading cooperatives to be more responsive to members’ needs

or to better product specifications. A cooperative usually has a patron list and collects a

substantial amount of information about member’s preference, needs, production

practices, and advice about products and services through periodic member surveys. The

members may be more willing to provide higher quality, more frequent, and more

truthful information to the cooperative than they would to an IOF (Cook, 1994) because

as owners they are more assured that the cooperative would not use the information to act

opportunistically toward them (Staatz, 1987). Another reason lies in the fact that “exit” is

a more expensive option for cooperative members than the patrons of IOFs (Cook, 1994).

Furthermore, an IOF CEO is usually in a position of strong control over both setting and

implementing company policies, while in cooperatives, the board of directors, as

representatives of members, are significantly more independent and would go a long way

towards monitoring the CEO. They do not feel beholden to question management

decisions and to reject its recommendations (USDA, 2002, p11).

Value added to the upstream farms and their owners Staatz (1987) observes that members are vitally interested in the cooperative’s pricing of

goods and services, not simply in its overall financial performance. Being users, they are

able to exert a higher influence on the operation and management of the firm than the

investors of an IOF, and consequently can receive more favorable prices. Members

benefit from the cooperative also in terms of product quality and other technical aspects

of products and services, which affect the profitability of their individual farm enterprise.

For instance, when an individual farmer cannot afford to do consumer research related to

characteristics of farm commodities, it might be feasible for a large cooperative to do

such research. An investor-owned marketing agency has little incentive to do it because it

cannot capture the benefits that accrue to farmers (Shaffer, 1987). In some cases,

cooperatives provide special services, particularly technical assistance, to members,

seeing the technician’s role as one of education and advice as well as service. Moreover,

the changes in cooperative profits can offset changes in member profits over expected

market cycles. “The stability to member returns would arise because variations in

member market prices are cancelled out by profit gains or loss at the cooperative level”

(Peterson & Anderson, 1996, p376). Peterson & Anderson (1996) report evidence that

3 The value added at the downstream cooperative firm is similar to the “owner value” defined by Staatz

(1987).

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some cooperatives take a conservative strategy by “saving” returns in good economic

times for “payout” in poor economic times. Next to that, cooperatives also prove to be an

assured source of supplies (Barton, 1989) and a reliable “home” for farm produce,

reducing risk to members (Lang, 1994). Members’ value as users is also reflected in the

cooperative’s diversification behavior. A cooperative never abandons the activities

concerning the majority of its members. Farmer cooperatives concentrate their

investments in agribusinesss and their assets are closely tied to the assets of their

members as the members might suffer substantial capital losses if their farming activities

were not adequately supported. In addition to the vertical information exchange that

benefit the cooperative firm, cooperatives also create a territorially based forum for

information exchange (LeVay, 1983) where members can more easily communicate

among each other. Shared information about safe pest control and other environmental

concerns is a prime example (Peterson & Anderson, 1996, p376).

It has long been recognized that value added to the upstream farms is likely to attract

more attention from the members. “The income that a stockholder derives from an IOF

depends on the firm’s ‘bottom line’, but the income of a cooperative’s stockholder often

depends more on the prices of the individual goods and services purchased from the

cooperative than on the organization’s overall profitability” (Staatz, 1987). There are

various possible explanations for the dominance of user value in the perception of

members. On the one hand, the limitation on dividend payments and the members’

inability to capture capital gains in a cooperative may account for member’s preference to

direct benefits in the form of transfer prices (Staatz, 1987). On the other hand, the

frequency of transactions may play a role. Cooperative members are users on an almost

daily basis, while owner-investors are only several times a year (tax day, equity

redemption day, dividend day). This frequent-use interface relative to the investor

interface reinforces a constant message that price and quality of the cooperative’s

services and goods affect the members’ bottom line, which is more important (in the

short run and for the individual member) than the bottom line of the cooperative (Cook,

1994).

Furthermore, members derive social value from being “a member of an association”.

Although members join the cooperative primarily for economic reasons, they pursue

some noneconomic objectives as well. “Benefits of social value include all noneconomic

results or outcomes of major interest or importance to stakeholders, including the

satisfaction many of them experience through the association, unity, and involvement

characteristics of member-controlled organizations. Some members like being involved

with others to achieve a common purpose. Some members also like electing or serving as

directors” (Barton 1989, p7). Members’ social value takes various forms. First, the fact of

membership and the possibility of holding directorial office yield satisfaction,

particularly for farmers who could not have contemplated running single-handed an extra

business next to their farms but feel more secure in a shared corporate undertaking

(LeVay, 1983). The pride and sense of responsibility associated with business ownership

is appreciated (Key and Roberts, 2009). Second, identity preservation can be a source of

member value (Lang, 1994). Identity influences economic choices and outcomes,

accounting for many phenomena that go beyond a standard economic explanation.

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Cooperative members have a different orientation in life than IOF shareholders. The

social values shared by them constitute the cooperative ideology. Forming a community

of cooperative members may appear to be a way of bolstering a sense of self or salving a

diminished self-image (Akerlof and Kranton, 2000). The result is that members feel more

cheerful, more confident and stronger, both in the market and in the society. Third,

cooperation is known to appeal to people not merely as a means of running a business but

also as an instrument of social amelioration (LeVay, 1983). Human beings have a strong

need to belong, either to a society or to a profession. Through various socialization

processes like member training programs and member relations programs, members work

together, learn together, celebrate together, and share their experiences together,

generalizing “feelings of family” to the entire membership.

2.2 CEO activities

A CEO’s tasks include setting long-term goals, establishing policies and standards,

determining long-term financing needs and sources, and setting strategies (Blanchard et

al, 1996). According to Merchant (1990), CEOs allocates their time over eight categories

of activities: 1) new product development, 2) improvement of existing products/services,

3) adjusting/improving production processes, 4) employee development, 5) capacity

expansion, 6) improvement of information systems, 7) execution of current production

processes, and 8) advertising and sales promotion. Of these eight categories, we classify 1

through 6 as actions attempting to build long term firm value, and categories 7 and 8 as

actions aiming at short term gains.

In addition to the activities mentioned above, a cooperative CEO needs to take actions

that create value for the upstream members because of the user-owner feature of

cooperatives. Three extra categories are specified:

9) Improvement of member involvement and member loyalty Compared with his IOF counterpart, the cooperative CEO is more interdependent and

interactive when coping with the user-owners. As a leader of a community-based

organization, he needs to be particularly effective in fostering group cohesiveness, a key

component in improving member loyalty.

10) Vertical information exchange A cooperative CEO once informed us that he spent at least half of his time

communicating with member patrons. Members have different preferences as to price,

cost allocation, and equity retirement polices, which affect both the cooperative and the

member enterprises. They have more formal and informal channels to communicate their

desires to the CEO than do patrons of an IOF and thus are able to exercise cheaper

“voice” (Staatz, 1987). Meanwhile, a cooperative CEO must actively acquire useful

information in discovering the optimal choice (Cook, 1994).

11) Member coordination and improvement of member relations A cooperative CEO takes a more integrated view of the members’ fixed costs when

attempting to optimize the vaguely defined objective function of the firm. The more

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heterogeneous the membership, the more will be the difficulty for the CEO to form

consensus and viable internal coalitions. The CEOs, particularly those of large,

diversified cooperatives, need to spend considerable time and effort in negotiating and

meeting the expectation of members. They are required to reduce the increasingly

heterogeneous interests to more homogeneous interests to capture the benefits of

coordination (Cook, 1994).

2.3 Governance

Most public-listed firms mitigate principal-agent conflicts through offering the CEO

incentive contracts that link pay to performance, whereas the complexity in measuring

cooperative performance often creates vagueness and lack of clarity in the eyes of

members (Cook, 1994). Designing and implementing an optimal incentive contract for

cooperative CEOs is therefore most likely different from the contract of an CEO of an

IOF.

First of all, the ‘plethora of objectives’ of members who differ in various aspects makes

the identification of the cooperative’s objective function one of the CEO’s most

challenging tasks (Cook, 1994). Yamay (1950) realizes that “the manager of a capitalist

enterprise knows what it should try to maximize and for whom, the management of a co-

operative society has a choice of what it should try to maximize (or minimize) and for

whom”. The shareholders of an IOF may be a diverse group as well, but capital markets

with a sufficiently rich menu of assets align their interests (Dixit, 1997). They are mostly

interested in the appreciation of their shares whereas the value of input suppliers is not

included in the value maximization of an IOF. In a cooperative, as membership grows

more heterogeneous, different groups within the organization pressure management to

respond to their particular interests. Because of the broader, more diffuse scope of

optimization in a cooperative (Staatz, 1987), single indicators such as ROI are less

meaningful as measures of organizational and managerial performance (Cook, 1994).

Consequently, evaluating whether a cooperative is achieving its objectives is far more

complex and delicate an undertaking than comparing ROI for IOF performance.

Secondly, there is no objective third-party indicator (besides members and the CEO) such

as secondary markets for cooperative stock to evaluate performance (Cook, 1994).

Investors of IOFs want to receive the highest possible return on their investment, and this

return can be expressed in the stock price. In other words, an IOF CEO’s contribution to

firm value is equivalent to the change in the shareholders’ wealth through appreciation of

the stock. Fluctuation in the stock price serves as an influential disciplining mechanism

on management, indicating the extent to which the stockholders are content with current

managerial policies. Many firms reinforce the potency by offering stock options to CEOs,

making their earnings contingent on the stock’s value.

Cooperatives lack this external mechanism for disciplining management. There is no

public financial assessment of the performance of the cooperative and therefore of its

CEO. Even though members are radically concerned with the prices the cooperative pays

for the goods from members or it charges for its services, the prices cannot be used as the

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sole performance measure, otherwise the CEO may be induced to decapitalize the firm in

an attempt to increase his current earning, simply reinforcing the horizon problem (Staatz,

1987). According to Hind (1997), as time progresses and the cooperative ages, the issues

of member service benefit would not be the sole goal of the business but that corporate-

oriented objectives would become increasingly important. However, market requirements

that best serve profitability goals of an IOF may not directly serve the immediate interests

of all cooperative members due to member heterogeneity. If a pure market-driven

approach is taken, members with less marketable inputs may not, compared to other

members, feel their needs are well met (Lang, 1994).

Cooperatives will look therefore for alternative measure to stock price so as to evaluate

how the corporate-oriented objectives are fulfilled. Accounting return measures are one

of the options. They have advantages as well as disadvantages compared to stock prices.

One might argue when accounting measures are used, temporary losses might be allowed

to establish sustainable future gains, as the lack of a stock listing makes temporary losses

less visible (Hendrikse and Veerman, 2001). However, accounting measures are often

criticized for inducing costly myopic behavior. They are aggregated and summarized, and

provide little indication of actions taken (Fisher, 1992). Managers can use the possibility

for manipulation provided by the latitude in accounting principles to maximize

compensation (Libby et al, 2002). Subsequently, any myopic actions taken to enhance

current accounting performance are not easily detected. At the same time, the cautious

nature of accounting rules which do not recognize uncertain gains and, in the U.S.,

require R&D investments to be fully expensed immediately, is also argued to cause

myopia (Bushee 1998, p306). For instance, the durable impact of continued training on

firm performance is not recognized as an asset by the accounting representation, and only

current revenues will pay it off. That is, training expenditure will be matched

immediately against them. Despite these shortcomings, accounting measures are not

completely uninformative.

Trechter et al (1997) observe that cooperatives link their CEOs bonuses to accounting

measures (such as accounts receivable) that are only weakly related to the cooperatives’

long-term goals, while some cooperatives do not even set long-term goals or formal long-

term planning procedure and goal-setting sessions. According to Cook (1995), horizon

problem pushes the cooperative management to accelerate members’ short-term benefits

at the expense of long-term earnings. We thus expect that the cooperative CEO would

give priorities to activities 7 and 8 that are specified in subsection 2.2 as actions

attempting to build short-term firm value whereas activities that aiming at long-term

value will be less important. We will investigate the impact of the use of accounting data

for performance measurement regarding short-term firm value.

There are a few sources providing some information about performance measurement in

cooperatives. First, Trechter et al. (1997) observe that some cooperatives use equity

redemption as a percentage of total equity and patronage refunds per member as factors

of the financial performance measure. Second, in 2008 Michael Cook has indicated to us

that his experience with various cooperatives regarding the compensation contract for a

CEO of a cooperative often specifies around 10 performance indicators, one of them

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being member satisfaction. Third, one cooperative has been willing to provide us with the

details of the determinants of the CEO bonus. On October 14, 2008 the head of the

personnel department of a dairy cooperative communicated to us that the bonus of the

CEO has a long run and a short run component. The long run component is exclusively

related to the milk price relative to a peer group of 6 other cooperatives. It captures two

features of the interests of the members. First, it captures that the price received by the

dairy farmers is a crucial aspect of the relationship of the farmers with the processor.

Four levels of the bonus are specified, related to ranking first, second, third, or lower in

the peer group. Second, continuity of the processor is important to the dairy farmers. This

is captured to a certain extent by the fact that the ranking is determined as an average

over 3 years. The short run component consists of three measurable performance

indicators. They are all related to the EBIT and goals formulated with respect to costs.

3 Basic model

This section develops a multi-task principal-agent model (Gibbons, 1998) to compare

CEO compensation schemes in two governance structures: cooperative and IOF. Assume

that the CEO in governance structure i (c for a cooperative and f for an IOF) can take two

actions: 1ia denoting the CEO’s action to advance the value of the downstream firm, and

2ia denoting the CEO’s action to add value to the upstream suppliers.

The CEO’s total contribution to firm value is denoted by iy , where i represents

governance structure (c for a cooperative and f for an IOF). The CEO takes various

actions to produce output. We denote action j in governance structure i by jia , and the

marginal product of jia by

jif . The production function is

1 1 2 2i i i i iy f a f a ,

where is a stochastic variable representing the noise in the production process that is

beyond the agent’s control.4 We assume that the expected value of is zero.

Given the difficulty in measuring the overall effect of the CEO’s actions on firm value,

no compensation contract based on iy can be enforced in court. Therefore, an alternative

performance measure ip becomes necessary. Suppose the technology of performance

measurement takes the form

1 1 2 2g a g ai i i i ip ,

where jig denotes the performance measurement parameter, i.e., the weight attached to

jia and denotes the noise in performance measurement. We assume the expected value

of is zero.

4 We assume the actions taken by the CEO only have consequences for the principal, which excludes the

possibility for the CEO to directly benefit from acting against the interests of the principal, i.e., the wealth

transfer between the principal and the agent is zero.

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Suppose the compensation contract in governance structure i specifies the wage iw paid

to the CEO as a linear function of ip . The compensation contract takes the form

i i i iw s b p ,

where is stands for the salary and ib for the bonus rate. Notice that with this specification,

the CEO’s incentives are to produce a high value of ip , not of iy , whereas the principal

does not directly benefit from increased realizations of measured performance ip , rather,

he benefits from increased realizations of the CEO’s total contribution iy . As a result, the

compensation incentives may be distorted. To minimize the distortion the principal has to

minimize the divergence between the CEO’s incentives to increase ip and the principal’s

desire for increases in iy .

The differences between a cooperative and an IOF are formulated in terms of restrictions

on the parameters in the production function and the performance measure. Firstly, the

CEO’s contribution to firm value depends on organizational form. In cooperatives, it is

equivalent to the change in total member value. Members want to bring both upstream

farms and the downstream cooperative to value, i.e., 1 20, 0c cf f . Investors of an IOF

care only about the firm value and consequently the CEO’s action that increase firm

value, i.e.,1 20, 0f ff f . Secondly, the performance measures of IOFs and

cooperatives differ. It is common in IOFs that the CEO’s bonus is paid in the form of

firm shares, i.e., 1 20, 0f fg g . However, cooperative members have no simple

indicator like stock price by which they can evaluate how well management has enhanced

the future earnings capacity of their cooperative firm (Staatz, 1987). Member interests are

usually present in the incentive scheme for the CEO of a cooperative, e.g. by

benchmarking the transfer price and production volume. This results in 1 20, 0c cg g .

To summarize, members’ plurality of interests is represented by 2 0cf , while the

absence of patron-members, and therefore serving their interests, in an IOF by 2 0fg .

The absence of public listing of a cooperative is embodied by 1 0cg5, while the use of

stock price in an IOF’s performance measure is captured by 1 0fg . The distinct features

of both governance structures are displayed in table 1.

5 We are not stating that a cooperative has no information at all about the downstream activities, but our

model will focus on the impact of lacking certain information.

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i

2f

f c

1if 0 0

2if 0 0

1ig 0 0

2ig 0 0

Table 1: Marginal product and performance measure parameters

Additional details of the model and the derivation of the equilibrium results are provided

in appendix 1. The efficient bonus rate is

* 1 1 2 2

2 2

1 2

i i i ii

i i

f g f gb

g g=

2 2

1 2

2 2

1 2

cos( )i i

i i

f f

g g,

where is the angle between vectors 1 2( , )i if f f and 1 2( , )i ig g g as depicted in figure 1

(Gibbons, 2004).

Figure 1: The scale and alignment effect of the performance measure

There are two important features in the expression of the efficient bonus rate, scale and

alignment. More specifically,

2 2

1 2

2 2

1 2

i i

i i

f f

g greflects the relative scales of the

vectors 1 2( , )i if f f and 1 2( , )i ig g g . A high value of

2 2

1 2

2 2

1 2

i i

i i

f f

g gindicates that the weights of

actions is higher in the production function than in the performance measure. As a result,

the firm will optimally increase the incentive intensity based on such a performance

Coefficient on 2a

Coefficient on 1a

1f 1g

2g

f

g

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g f

measure. Furthermore, cos( ) captures the alignment effect. To the extent that the

performance measure induces CEO’s actions less aligned with firm value, will increase,

and the performance measure will distort incentives more (Baker 2002). As a result, the

firm will optimally reduce the slope of the incentive contract based on such a

performance measure. Decreased alignment decreases the incentive intensity, and

therefore increases the fixed wage, in the compensation package of the CEO.

As shown in figure 2, the production function and performance measure are perfectly

aligned in an IOF, i.e., f and g overlap, so the performance measure has no distortion. In

this case the efficient bonus rate depends solely on the comparative scales of 1 ff and 1 fg .

Figure 2: The scale and alignment effect in an IOF

A cooperative and an IOF differ in the basic model because f and g are not aligned in a

cooperative (figure 3). The production function depends on two actions while the

performance measure is determined by only one of them. The formula of cooperative

efficient bonus rate *

2 2/c c cb f g is rather interesting. Our specification of the

cooperative case is equivalent to a situation where 1 0cf and 1 0cg , that is, the

production function and performance measure both compose of only one action, like an

IOF. The implication is that the appearance of 1ca in the production function does not

make any difference in the efficient bonus rate and consequently in the CEO’s

equilibrium actions. In other words, when an action increases the member value without

simultaneously increasing the performance measure, the CEO has no incentives to

undertake it.

Coefficient on 1a

Coefficient on 2a

14

2f

Figure 3: The scale and alignment effect in a cooperative

In equilibrium, an IOF CEO has incentives to undertake only 1 fa , i.e., *

1 0fa , because

the investors care about 1 fa and make the CEO’s pay dependent on 1 fa . Members of

cooperatives, however, appreciate the CEO’s actions on both dimensions but only

compensate for 2ca . Thus, only an incentive to increase 2ca is created ( *

2 0ca ) and no

incentive for 1ca exists even though it would increase firm value.

Proposition 1: The misalignment between members’ value and the cooperative CEO’s

interest results in the CEO’s failure to add value to the downstream cooperative firm

while the perfect interest alignment between the investors and the IOF CEO creates an

incentive for the CEO to advance the firm value.

When the available performance measures are incomplete, the incentive contract will lead

to problems of distortion, or as Kerr (1975) put it: “the folly of rewarding A while hoping

for B”. With the complex and sometimes ambiguous goals of cooperatives, the incentive

contact may provide only a partial representation of its objectives. The misalignment

between performance measure and production function persuades the CEO to pay

unbalanced attention to actions that positively affect their scores on the performance

measures, neglecting areas for which performance is not assessed. Therefore, we expect

that a cooperative CEO would give priorities to activities 9-11 specified in section 2.2,

the actions that add value to the upstream member farms.

To compare the efficiency of the two governance structures, suppose there is another

upstream IOF consisting of a farmer as the principal and a CEO as agent (see appendix 1).

A fair comparison entails comparing the value created by a cooperative with the joint

value created by a downstream and an upstream IOF. Simple calculations show that the

total surplus of a cooperative and two IOFs are 2

2

1

2f and 2 2

1 2

1( )

2f f respectively. The

total surplus created by a cooperative is always less than the surplus created by the two

Coefficient on 2a

Coefficient on 1a

f

1f

g

15

IOFs when 1 0f , i.e. the cooperative is inefficient. The behavior of the cooperative

CEO is exactly the same as the behavior of the CEO of the upstream IOF. Value would

be created in the cooperative by developing downstream activities because 1cf o , but

the cooperative CEO will not choose these activities because the performance measure

does not put any weight on them. The difference in value creation between the two

governance structures is therefore equal to the value created at the downstream IOF.

Proposition 2: A cooperative is inefficient.

Another way to explain the result is that the cooperative is supposed to serve member

interests and to generate maximum value in processing. However, the organizational

structures required for the upstream and downstream tasks differ. The cooperative is

designed for the former task, and therefore does not always perform the latter task well.

The governance structure IOF consists of two organizational structures, i.e. a downstream

and an upstream IOF. It is tailored to each task separately. The next section will

determine that this result depends on the two activities being independent in the above

model.

4 Extensions

In this section, several extensions of the basic model are made to further contrast the

CEO compensation in cooperatives versus IOFs. Section 4.1 addresses the relationship

between membership composition and CEO compensation. Section 4.2 relaxes the

assumption that the downstream and upstream activities are independent. Additional

information in the performance measure is considered in section 4.3. Finally, section 4.4

addresses strategic aspects of the choice of performance measure.

4.1 Society of Members

The basic model have referred to members in general, but no attention has been paid to

the composition of the membership. The results (regarding the effect of alignment

between the CEO’s production function and performance measure on the efficient bonus

rate and the CEO’s choice of actions) can be best understood as the extent to which the

CEO’s interest accords with the average member’ interest. Now we turn to explore the

impact of membership size (4.1.1) and member interest alignment (4.1.2) on the strength

of incentives for a cooperative CEO.

4.1.1 Membership size

In the standard principal-agent model, the agent is usually assumed to be risk averse

whereas the principal is assumed to be risk neutral. The assumption that the principal is

risk neutral will be relaxed. Members are different from investors of an IOF because the

latter are more risk preferring or diversify their portfolio to spread risks. Due to the

immobility of cooperative capital, members usually exhibit financial commitment to a

particular line of business, having all their eggs in one basket (Staatz, 1987).

16

Suppose there are n members in the cooperative who value the CEO’s actions identically

(Dixit, 2002). The CEO’s contribution to member q is

( ) 1 1 2 2

1 1qy f a f a

n n.

Consequently the CEO’s total contribution to the society of members is

( ) 1 1 2 2q

n

y f a f a n .

As all members will agree on a single way of evaluating the CEO, the performance

measure remains

1 1 2 2p g a g a .

Assume errors are independent.

Let r denote the CEO’s risk aversion, R the risk aversion of each member, v’ the variance

of , and v the variance of . It can be shown that the joint risk aversion of the members

0R when they act collusively and pool risks is

0

1 1

n

n

R R R,

i.e., the existence of multiple members in a cooperative decreases members’ joint risk

aversion. The impact on the efficient bonus rate of the cooperative CEO is

* 2 2

2

2 ( / )

f gb

g v r R n.

i.e., a larger society of members decreases the efficient bonus rate. This is in line with the

results in the standard principal-agent problem regarding risk-aversion. If the agent

becomes more risk-averse, then the equilibrium compensation scheme specifies a lower

incentive intensity and higher base wage. In this section it is the increasing ability of a

larger membership to bear risk which widens the gap with the risk aversion of the CEO.

Proposition 3: The incentive of a cooperative CEO is weakened when the number of

members increases.

4.1.2 Member heterogeneity

This section varies the heterogeneity of the membership while keeping the size of the

membership fixed. Hansmann (1996) stresses the importance of the interest homogeneity

among members for the efficiency of decision-making. However, cooperative members

do often not resemble each other in terms of interests. They differs in various dimensions,

like age, location, size, their investment portfolio, amount of capital investment, social

background, attitude towards risk, and being an active or retired member. Members will

have therefore different preferences regarding the decisions made by the cooperative. For

example, good performance for the inactive or over-invested member means the amount

of returned equity, but good performance for the under-invested or new member means

the competitiveness of current prices or services (Cook, 1994).

17

We investigate in this subsection the effect of member interest alignment, the reverse of

member heterogeneity, on the strength of incentives for a cooperative CEO. Member

interest alignment is defined as the extent to which the production function of each

member accords with that of the average member. Suppose n cooperative members value

the CEO’s action 2a differently. That is, the CEO’s contribution to member q is

( ) 1 1 2( ) 2 ( )

1 1q q qy f a f a

n n,

where 2( )qf denotes the value member q assigns to 2a , and consequently the CEO’s total

contribution to the society of members is

( ) 1 1 2 2 ( )q q

n n

y f a f a , where 2 2( )q

q

f f .

Now the joint risk aversion of the members 0R becomes

0 ( )

1 1

n qR R,

where qR denotes the risk aversion of member q.

Other conditions remain the same as in the previous subsection6, the efficient value of b

remains

* 2 2

2

2 0( )

f gb

g v r R.

It can be shown that if the sum of all member’s risk aversions is fixed, 0R and the

efficient bonus rate reach the maximum when members have identical risk aversions. In

other words, the heterogeneity of the members’ risk aversions leads to lower joint risk

aversion and consequently a lower efficient bonus rate.

Proposition 4: Increasing heterogeneity in the members’ risk aversions leads to impaired

CEO incentives.

This proposition provides an explanation for the phenomenon that compared with

investors of an IOF, members of a cooperative usually are more homogeneous with

regard to their social backgrounds, investment portfolios, attitudes towards risk, and so

on. This finding suggest that the negative relationship between member heterogeneity and

the strength of CEO incentives might be one of the considerations regarding the evolution

of membership heterogeneity in the course of time. The membership may be quite

heterogeneous at the founding stage of a cooperative, but the development of

cooperatives are geared towards attracting more homogeneous members and encouraging

heterogeneous members to leave in subsequent stages. This reduces the impact of

member heterogeneity on the incentive intensity of the CEO.

6Notice that members value the actions taken by the CEO differently but have to reach a consensus on the

bonus rate of the CEO’s payment scheme.

18

4.2 Substitutable / complementary tasks

The upstream and downstream tasks of the CEO in the basic model are independent.

Following Dixit (2002), we relax this assumption by analyzing the substitutes or

complements effects of actions. An examples of substituting tasks of the CEO is the time

he spends in communicating with the input suppliers and the time he spends on the

business strategies of the downstream firm. When the workload of the CEO is fixed, the

more he works with the suppliers, the less time left to spend on the firm strategies.

Examples of complementary tasks can be the CEO’s coordination between the upstream

suppliers and the downstream enterprise. More knowledge of one side facilitates

coordination with the other side. The main result is that 2 fa and 1ca are not zero anymore.

Their actual levels will depend on the nature and the strength of the interaction effects.

The equilibrium results with substitutable/complementary tasks are in appendix 2. Let *

( )i kb and *

( )ji ka denote respectively the equilibrium bonus rate and action on task j in

governance i when the interaction between tasks in the cost function is k. The two tasks

are substitutes when 0<k<1, complements when -1<k<0.

In the basic model, an IOF CEO will in equilibrium take no action 1 fa . However, the

marginal cost of 1 fa decreases with

2 fa in the complementary case and increases in the

substitutes case. If 2 fa can make 1 fa less costly, the CEO will optimally choose to take

some actions 2 fa , which will further increase the equilibrium level of 1 ( )f ka as compared

with *

1 (0)fa . The stronger is the complementary effect, the more actions will be taken on

2 fa . If 2 fa makes 1 fa more costly, he will take a negative action on 2 fa since it will

decrease the marginal cost of action 1 fa . As a result of the decreased marginal cost, the

equilibrium level of 1 ( )f ka increases.

Proposition 5: When tasks are complementary, the IOF’s CEO will take actions to

increase the upstream supplier’s value, i.e., * *

2 ( ) 2 (0) 0f k fa a and *

2 ( )f ka decreases with

k. When tasks are substitutes, he will take actions to decrease the upstream supplier’s

value, i.e., *

2 ( ) 0f ka . And the CEO’s action advancing the downstream value increases,

i.e., * *

1 ( ) 1 (0)f k fa a , regardless the nature of the interaction between tasks.

In the basic model, a cooperative CEO will in equilibrium take no action to increase the

downstream enterprise’s value. However, if two actions are complementary, he will

optimally choose to take positive action on 1ca , which in turn increases the equilibrium

level of 2 ( )c ka as compared with *

2 (0)ca . The stronger is the complementary effect, the

higher are the equilibrium levels of 1 ( )c ka and 2 ( )c ka .

19

Proposition 6: When the cooperative CEO has two complementary tasks, he will take

actions to boost the value of the downstream stage and his equilibrium action to bring the

upstream farm to value will also increase, i.e., * *

1 ( ) 1 (0) 0c k ca a , * *

2 ( ) 2 (0)c k ca a , and both

*

1 ( )c ka and *

2 ( )c ka decrease with k .

Because 2 20, 0f ff g ,

1( ,0)ff f and 1( ,0)ig g are perfectly aligned, the efficient

bonus rate of an IOF’s CEO is determined only by the scale of 1( ,0)ff f and 1( ,0)ig g ,

i.e., 1 1/f ff g . Therefore, the interaction between actions has no influence on the efficient

bonus rate in an IOF, i.e., * *

( ) (0)f k fb b .

When the cooperative CEO has complementary tasks, a high bonus rate leads to a high

level of *

2 ( )c ka , which will result in higher *

1 ( )c ka due to the complementation effect.

Therefore, a principal valuing both actions has incentives to increase the bonus rate of

2ca so as to increase both actions. The stronger is the complementary effect, the larger is

the efficient bonus rate. When the two tasks are substitutes, a high bonus rate on

2ca drives the CEO to exert as much effort as possible to 2ca while taking no action or

even negative action on 1ca . Therefore, the principal will cut down the bonus rate. The

stronger is the substituting effect, the smaller is the efficient bonus rate.

Proposition 7: The efficient bonus rate in a cooperative increases (decreases) when the

CEO’s tasks are complementary (substitutes), i.e., * *

( ) (0)c k cb b when -1<k<0; * *

( ) (0)c k cb b

when 0<k<1. Furthermore, *

( )c kb decreases with k.

Interactions between the downstream and upstream activities may make the cooperative

the unique efficient governance structure. These interactions in the cost function elicit

new activities by the various CEOs. The cooperative CEO will choose a positive level of

the downstream activities, downstream activities are chosen also by the CEO at the

upstream IOF, and upstream activities are put forward by the CEO at the downstream

IOF. It turns out that the equilibrium level of upstream activities generated by the

cooperative is identical to the level of upstream activities by the two IOFs together, while

the level of downstream activities generated by the cooperative is lower than the level of

downstream activities by the two IOFs together. Total revenues in a cooperative are

therefore lower than in the IOFs. However, the decrease in total costs in a cooperative is

even higher when the complementarities are sufficiently strong. The reason is that the

decrease in the downstream activities by the cooperative CEO is limited due to 1cf o .

This makes the cooperative the unique efficient governance structure when the

complementarities are sufficiently strong, despite that the downstream activities are not

recognized in the performance measurement scheme facing the cooperative CEO. (The

cooperative is never efficient when the downstream and upstream activities are

substitutes or independent.) The cooperative internalizes externalities to a certain extent

by putting positive weight on serving member interests and generating maximum value in

20

processing. Not having a public listing provides the cooperative with a commitment not

to choose the level of the downstream activities too high.

Proposition 8: A cooperative is uniquely efficient if and only if 1 22

2

1

kf f

k.

Another implication of this proposition is that cooperatives are expected in sectors where

the marginal productivity (at the downstream stage) is below a certain level, given the

strength of the complementarities and the marginal productivity at the upstream stage of

production.

4.3 Additional information in the performance measure

The breath of scope in cooperative goals makes defining task achievement more difficult

(Cook, 1994). The absence of stock price increases the difficulty in measuring the CEO

performance. Many cooperatives try to correct for this by using more than one measure.

We investigate two ways of adding extra information in the performance measure.

Subsection 4.3.1 decomposes the cooperative CEO’s action 1ca into two aspects, one

aiming at long-term value and the other aiming at short-term benefits based on

accounting measures. Subsection 4.3.2 introduces the use of a subjective performance

measure.

4.2.1 Public versus accounting data

In order to distinguish the long-term and short-term impact of accounting measures on

enterprise value, we decompose 1ia into two actions, 1ila and 1isa , each denoting the

CEO’s action to boost long-term and short-term firm value. The marginal product and

performance measure parameters of actions are respectively 1ilf and 1isf , 1ilg and 1isg .

Table 2 shows the distinctions between cooperatives with or without accounting

measures in their CEO compensation measurement, where c” stands for a cooperative

using accounting measures to evaluate its CEO’s action. It represents that a publicly

listed firm can use both long-term and short-term incentives; a cooperative using

accounting data gives its CEO only short-term incentives regarding the cooperative firm,

while a cooperative that does not use accounting data has neither.

21

i f c c”

1ilf 0 0 0

1isf 0 0 0

2if 0 0 0

1ilg 0 0 0

1isg 0 0 0

2ig 0 0 0

Table 2: The differences between cooperatives with (c”) or without (c) accounting

measures in their CEO compensation measurement

It is straightforward that 1 '' 0c sa and 2 '' 0ca . The use of accounting data helps at least

motivate the cooperative CEO to pay attention to the downstream enterprise, though it is

likely to overly accentuate the short-run revenue, rather than the long-run interests.

Proposition 9: By including accounting measures, the CEO’s performance measure are

better aligned with the production function, and the CEO has incentives to advance both

the value of upstream member farms and the short-run goals of the cooperative firm.

We consider again when a cooperative is efficient. No general expression has been

established yet, but various numerical examples have been identified. Proposition

presents and example.

Proposition 10: By including accounting measures, a cooperative is more efficient than

the IOFs when 2 21, 100, 10l l s sf f g f g g .

4.3.2 Subjective performance assessment

In previous sections, we discuss only objective performance measures utilized to evaluate

the CEO’s contribution to the firm, which according to Gibbons (1998) are typically not

sufficient to create ideal incentives. Stock price, for example, involves too much noise

and external influences that are beyond the CEO’s control. The uncertainty of agriculture

in particular “hampers tying a bonus to easily measured performance indicators that a

CEO can control and that are of value of the cooperative” (Trechter et al, 1997).

Moreover, paying the management for the current earnings or profits sometimes goes at

the expense of long-term firm value. Activities that do not create immediate short-term

profits though redound to long-term development, like R&D, might be underinvested.

In multi-task settings, it is often helpful to use multiple instruments to provide a balanced

package of incentives. For instance, many firms mitigate the effects of distortionary

objective performance measures by augmenting objective measures with subjective

performance assessments even where the objective aspects of an individual’s contribution

22

to firm value are easily measured. Subjective measures refer to a judgment by the

supervisor of the subordinates’ performance, including a judgment of the actions taken to

achieve that performance. Subjective evaluations can take different forms, such as (1)

flexible weighting of objective performance measures ex-post (at the end of the

evaluation period); (2) the use of subjective (qualitative) measures; (3) discretion in using

additional performance criteria (Ittner, 2003). They are more useful when decisions affect

results further in the future (Lambert & Larcker, 1987). Subjectivity allows the supervisor

to correct for dysfunctional behavior, such as myopia, induced by incomplete

performance measures (Gibbons, 1998). Valuation in the CEO’s current cash

compensation not explained by current performance measures (such as stock return, sales,

and earnings) predicts future variation in these performance measures. Empirical

evidences prove that when subjective evaluation is used to a higher degree, CEO

compensation is more positively related to future earnings (Hayes & Schaefer, 2000).

Furthermore, the use of subjectivity in evaluations has been found to increase with firm

growth opportunities and product life cycle length (Bushman et al. 1996).

The cooperatives may use subjective performance assessment to reconcile the short-term

orientation indicated earlier and motivate managers to undertake actions with longer-term

managerial focus and consequences. The geographic proximity of patrons to their firm

may also create stronger social ties between management and owners. The fact that the

patrons are in a privileged position to observe and monitor managerial operations and

there are stable long-run relationships between owners and CEOs, suggests greater

reliance on subjective performance evaluation in cooperatives (Hueth & Marcoul, 2008).

As a result, “the incentive and compensation system encourages good long-run

performance and is not driven by favorable or unfavorable short-run fluctuations”

(Trechter et al, 1997). That is, the performance of the cooperative CEO should be

subjectively assessed by board of directors who are well placed to observe the subtleties

of the CEO’s behavior and opportunities. As discussed earlier, the board of directors in

cooperatives, as representatives of members, is significantly more independent than their

IOF counterparts are, and are better motivated to monitor the CEO. They interact with

management both in the boardroom, and as patrons, they potentially have more

information about the production environment in which the CEO operate (Hueth &

Marcoul, 2008). In additional, the patrons’ vested interest in the performance of the

cooperative and its CEO may reduce agency problems. Because the patrons are also the

owners, virtually every transaction in the cooperative involves a principal who can

oversee the agent’s actions(Trechter et al, 1997). So the patrons’ feedback and general

level of satisfaction (for instance, regarding equipment maintenance and access to desired

services), and occasionally, from employees, can also be part of the subjective

assessment (Trechter et al, 1997).

We provide no formal modelling regarding subjective performance assessment in this

section because it is similar to modelling the impact of incorporating accounting data.

The only difference is that the labels regarding short and long run have to be replaced.

However, the impact on alignment is the same. Incorporating subjective performance

assessments in the performance measurement will improve alignment, and therefore the

23

incentive intensity in the compensation scheme of the cooperative CEO.

4.4 Strategic choice of performance measure

The previous subsections have focused on determining the optimal incentive intensity in

various environments, while the production function and performance measure

parameters were exogenously determined. Baker (2000, p419) observes that ‘The choice

of which performance measure to use ( and the weights to place on them) depends on

how the amount of distortion and the amount of risk change as one moves from one

performance measure to another’. It is obvious in our model that the weights in the

performance measure have to be chosen to establish alignment with the production

function parameters. However, this result may change when the enterprise is facing a

competitor. This subsection argues that there may be a strategic rationale involved in the

choice of the weights of a performance measure. An early contribution is Vickers (1985).

The strategic choice of performance measure can be incorporated in the two-stage game

by adding an additional stage at the beginning of the game. That is, the principals decide

first regarding the weight attached to each activity in the performance measure, and

subsequently they choose the incentive intensity. Finally the CEO chooses his action

levels. The other ingredient needed for studying strategic performance measurement

choice is that there is (potential) competition between enterprises, i.e., there have to be at

least two enterprises.

According to Fudenberg and Tirole (1984), three variables have to be specified in order

to determine the payoff maximizing choice of performance measure in a strategic setting:

the nature of investment, the nature of the competitive process, and the entry condition.

First, define the investment as the extent of member focus in the performance measure. If

the extent of member focus is large, i.e.,2g is much higher than 1g , then the profits of the

rival firm will increase. The reason is that the CEO of the cooperative will dedicate a

larger part of his time to activities related to the interests of members when the extent of

member focus changes from small (S) to large (L), which goes at the expense of activities

geared towards developing the cooperative enterprise. It entails that the investment is soft,

because it establishes a positive relationship between investment in the weight of member

focus in the performance measure and profits of the rival firm. Second, assume that the

nature of the competitive process is characterized by strategic substitutes, i.e. reaction

functions are downward sloping (figure 6). Third, two cases regarding the possibilities of

market entry have to be distinguished (Fudenberg and Tirole, 1984): entry is inevitable or

it is not. If entry is not inevitable, then a monopoly market structure arises endogenously

by the choices of the two enterprises. Otherwise it is always a duopoly.

The profit maximizing investment profile of the cooperative is to be aggressive in order

to elicit a passive response by the rival, i.e. underinvestment in the weight put on member

focus in the performance measure. Notice that no distinction has to be made regarding the

entry condition. The payoff maximizing investment choice is the same in both cases

because the market is characterized by a soft investment and strategic substitutes. This

result is summarized in the next proposition.

24

Proposition 11: A cooperative puts a low weight on member focus in its performance

measure in order to elicit passive behavior from a rival enterprise.

Figure 6: Performance measure choice and reaction functions

5 Empirical implications

The differences between the two governance structures, cooperatives and IOFs, entails

different actions taken by their CEOs. we will translate the results of our previous

analysis regarding CEO’s choice of actions into their empirical implications.

5.1 Growth

Caves & Petersen (1986) observe that a local cooperative usually serves a fixed

membership base. It does not compete with neighboring cooperatives, so that horizontal

expansion is precluded except by merger. We hypothesize similarly that the growth in

cooperatives is slower that in IOFs for the following reasons. First, proposition 1 predicts

that the cooperative CEO spend less effort to advance the downstream value, leading to

slower growth in cooperative enterprises than in IOFs.

Second, nonmarketability of cooperative equity implies differences in attitudes towards

growth between cooperatives and IOFs. Growth is the single most important determinant

of stock price (Holmström, 1999). The growth of an IOF results in appreciation of equity,

which can be realized by investors through selling their shares in the secondary market.

An IOF CEO has thus incentives to accelerate the firm growth when his own pay and

tenure are strongly tied to the stock price (Lerman, 1991). The nonmarketability of

cooperative equity, on the other hand, provides no incentives for the cooperative CEO to

pursue firm growth.

Third, growth requires financing and cooperatives, because of their unique form of

organization, are usually viewed as equity bound (Lerman, 1991; Vitaliano, 1983).

Cooperatives acquire financial resources in two ways, externally or internally. First, it is

expensive for a cooperative to obtain outside equity due to the feature that members are,

QIOF

QCOOP

RIOF

RC(S)RC(L)

25

by definition, the residual claimants in a cooperative. Second, because the return obtained

by a cooperative member depends on his volume of transactions, rather than how much

he invested, he has an incentive to free ride by supplying as little capital as possible. A

new member will seek to understate his planned transaction volume when he joins.

Initially the cooperative may grow faster than an IOF since it does not pay corporation

income tax on its earnings from business with members. However, when the rotation of

equity begins, the cooperative’s maximum growth rate might drop abruptly and continue

to decline toward a steady-state level below the steady-state level that the IOF can

achieve (Caves & Petersen, 1986). In contrast, IOFs have better access to new equity.

They can retain earnings and raise additional equity in the stock market from any investor

who is willing to take the risk. Moreover, they can use their own stock to pay for

acquisitions (Hendrikse & van Oijen, 2009).

5.2 Upstream versus downstream innovation

The establishment of a cooperative contributes to both the value of the cooperative

enterprise itself but also to its members. The innovation activities in a cooperative can

also be distinguished into upstream and downstream innovation. The upstream innovation

mainly concerns the process innovation related to the existing products while the

downstream innovation concerns development of new products. Based on proposition 1

we expect that the cooperatives focus more on upstream innovation with regard to the

existing products than on downstream innovation.

Cooperatives, according to many, are at a disadvantage in the innovation race with IOFs.

For instance, Thirkell (1989, p14) claims that cooperatives are generally not innovative or

progressive. Given the discussion in previous sections, the emphasis of a cooperative on

upstream member benefits entails that the process innovation in members’ close interests

is not necessarily ineffective or inactive as compared with that in an IOF. A cooperative

normally only processes (or markets) the products from its members, and this makes

product-orientation a characteristic of the cooperative business form. Furthermore, the

fact that members have expertise and will bring new ideas about their products will

strengthen the cooperative’s search for product related differentiation.

Yet, we agree with Thirkell (1994) when it comes to the corporate oriented downstream

innovation for the following reasons. First, the hierarchical investment approval process

of cooperatives with internal capital markets is an impediment to innovation within firms,

resulting in less innovation in cooperatives compared with IOFs. Secondly, innovation is

likely to divide opinions within the cooperative, because young members are typically

more eager to invest in future activities than are the old, soon-to-retire members. As a

consequence, there will be less opportunities for management to experiment and explore.

Thirdly, outside investors are unwilling to provide capital needed for innovation if they

can hardly control the cooperatives. Finally, stock price as a powerful measure to

evaluate and reward innovative activities is missing, depriving management and

employees of the most effective guide for such activities (Holmström, 1999).

5.3 Diversification

26

Diversification choices of an IOF aim to maximize the net returns of the investors, while

the diversification choices of a cooperative are guided by bringing to value the portfolio

of members (Hendrikse and van Oijen, 2009). We expect that cooperatives are less

diversified than IOFs. On the one hand, lacking of financial resource as discussed in

previous subsections makes it more difficult for cooperatives to carry out diversification.

On the other hand, the diversification decisions in a cooperative are often biased or

delayed by internal influence activities. Members have a lot in stake on what the

cooperative does. They have product, technology and other firm specific knowledge,

which may become valueless if the cooperative changes course and pursues new ideas

and lines of business. If the transition requires entirely new knowledge, resistance to

change can be enormous (Holmström, 1999). The less powerful position of the CEO in

cooperatives compared to IOFs reinforces this tendency (Hendrikse & van Oijen, 2009)

When it comes to if cooperatives and IOFs differ with respect to the diversification

behaviors, based on the current model we have different prediction from Hendrikse &

van Oijen (2009). They show that cooperatives diversify relatively more into unrelated

activities than IOFs do whereas we take the opposite position. When a cooperative

diversifies into related activities, the new actions entailed by the diversification can be

complementary to the existing actions of the CEO. According to proposition 6 when the

CEO has complementary actions, he will exert effort on both even if one of the actions is

not evaluated and compensated. Thus, we expect the members would encourage the

complementary actions to balance upstream and downstream value. Caves & Petersen

(1986) also argue that cooperative organizations are ill-suited to entrepreneurial tasks that

entail activities far removed from the direct interests and experience of the cooperative

members. In other words, its possibilities for diversifying are limited. One might say that

a cooperative focus more on searching markets for sale instead of searching for market

opportunities.

Cooperative members, like any other sellers, would desire brisk sales, but they are

usually involved in the production of a small number of different produces, for the scale

of economy reason. Consequently, the cooperatives usually focus on the products that

concern most of its members, and therefore diversify within a more narrow scope of

portfolio. The fact that they do not diversify widely as many IOFs do nowadays may have

impact on growth.

6 Conclusions and further research

The evaluation and measurement of CEO performance is complex, especially in

cooperatives where members have differing preferences and no public listing can be used

as performance indicator. While regulators and shareholders of an IOF may find it

beneficial to encourage the use of equity-based compensation (Bebchuk and Fried, 2003),

a pay package that is very sensitive to any single performance measure will bring about

distortion and inefficiency in cooperatives.

27

In reality, the CEO compensation schemes in cooperatives vary. Some use pre-set

performance-based bonuses, some allow for bonuses paid on past performance, and

others do not use bonuses (Trechter et al, 1997). However, previous research has not

considered the optimal design of compensation contract for cooperative management. In

the current paper, we study the principal-agent tension between a cooperative CEO and

members. Different structures of the CEO compensation are identified, as well as the

behavioral differences of a cooperative CEO and an IOF CEO. Results are formulated

regarding the sensitivity of the optimal incentive intensity to the nature of CEO activities,

to additional information, to membership composition in terms of size and heterogeneity,

and strategic considerations. Circumstances are formulated when the cooperative is the

unique efficient governance structure.

As far as we know, this paper is the first attempt to model the compensation scheme of

cooperative CEOs. Much more is to be done. First, data regarding CEO pay composition

and behavior is much needed in order to inform research regarding cooperatives. Second,

further research may incorporate the internal control mechanism in cooperatives. The

board of directors consisting of members is usually elected by and from the membership,

and is commonly representing member interests. They have more access to information

inside the organization and have more at stake in the cooperative than their counterparts

in IOFs have, and are thus expected to be a more active monitor and participant. Third,

Trechter et al. (1997) is right that the CEO is important for the success of a cooperative.

However, enterprises have a variety of means to address coordination and motivation

problems, of which CEO compensation is one. Other instruments have therefore to be

considered in combination with CEO compensation.

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32

Appendix 1

The model consists of a two-stage non-cooperative game (Gibbons, 2004). In the first

stage, the principal chooses the strength of incentives while the agent (i.e., the CEO)’s

optimal choice of activities is determined in the second stage of the game.

Three activities are distinguished in order to cover the cases of section 3 as well as

section 4. The production function is therefore

1 1 2 2 3 3i i i i i i iy f a f a f a .The technology of performance measurement takes the form

1 1 2 2 3 3g a g a g ai i i i i i ip .

We assume now that both the principal and the agent are risk neutral. The principal

receives the CEO’s total contribution to firm value, but has to pay the CEO’s wage. The

principal’s payoff is the difference between the value received and the wage paid:

i i iy w .

The CEO receives the wage but has to take costly actions to produce output. The cost

associated with the actions 1 2 3, ,i i ia a a is defined as

2 2 2

1 2 31 2 3( , , )

2 2 2

i i ii i i i

a a ac a a a

The CEO’s payoff is the difference between the wage received and the cost of the actions

taken:

1 2 3( , , )i i i i i iU w c a a a .

We use backward induction to solve the two-stage non-cooperative game. We start from

the second stage of the game. The CEO’s optimal action is determined by maximizing his

expected utility, i.e.,

1 2 3, ,max ( )ia a a

E U ,

where

1 2 3 1 1 2 2 3 3 1 2 3( ) [ ( , , )] (g a g a g a ) ( , , )i i i i i i i i i i i i i i i i i iE U E w c a a a s b c a a a .

Setting the first derivative of the expected utility with respect to jia equal to zero results

in the first order condition

ii ji

ji

cb g

a, 1, 2,3j .

This characterizes the CEO’s optimal actions * ( )ji ia b .

33

The payoff-maximizing reply in the second stage of the game is anticipated in the first

stage when the principal determines the efficient intensity of incentives ib . The efficient

ib is determined by maximizing the expected total surplus

max ( )i

i ib

E U ,

where * * * * * *

1 2 3 1 1 2 2 3 3 1 2 3( ) [ ( , , )] ( , , )i i i i i i i i i i i i i i i i iE U E y c a a a f a f a f a c a a a .

When the CEO takes only two actions, it can be shown that * ( )ji i i jia b b g

and

* 1 1 2 2

2 2

1 2

i i i ii

i i

f g f gb

g g.

The efficient bonus rates of an IOF and a cooperative are therefore *

1 1/f f fb f g , *

2 2/c c cb f g .

Plugging these results in the expressions for the CEO’s equilibrium actions results in *

1 1 1( )f f f f fa b g b f , *

2 0fa

and *

1 0ca , *

2 2 2( )c c c c ca b g b f .

In order to facilitate comparing the efficiency of a cooperative versus the IOFs, we

assume that the marginal product and the performance measurement parameter of each

activity remain the same across different governance structure. For example, 1f and 2g

for 1a for a cooperative, an upstream and a downstream IOF. Therefore the above results

become

*

1 1/fb f g , *

2 2/cb f g , *

1 1fa f , *

2 0fa , *

1 0ca , *

2 2ca f .

Similarly, the equilibrium results for an upstream IOF are: *

2 2/ufb f g , *

1 0ufa , and *

2 2ufa f .

Appendix 2

Assume again that the CEO can take only two actions 1ia and 2ia , and the cost function

takes the form 2 2

1 21 2 1 2( , )

2 2

i ii i i i i

a ac a a ka a , where -1<k<1.

When 0<k<1, the two tasks are substitutes, i.e., more effort in 1ia increases the marginal

cost of effort in 2ia , therefore enhancing the marginal incentive payment for greater

output of 1ia draws effort away from

2ia . When -1<k<0, the two tasks are complements,

implying that the interaction between the two tasks strengthens incentives for both.

34

With the new cost function, the efficient bonus rates for a firm and a cooperative are:

1*

( )

1

f

f k

f

fb

g and * 2 1

( )

2

( )c cc k

c

f kfb

g.

Plugging these results in the expressions for the CEO’s equilibrium actions results in

1*

1 ( ) 21

f

f k

fa

k,

1*

2 ( ) 21

f

f k

kfa

k,

* 2 11 ( ) 2

( )

1

c cc k

k f kfa

k, * 2 1

2 ( ) 21

c cc k

f kfa

k.

Similarly, the equilibrium results for an upstream IOF are:

*

2 2/ufb f g , *

1 221uf

ka f

k, and *

2 22

1

1ufa f

k.